Latin America's non-linear response to pandemic inflation

Summary

Focus

Over the past 15 years, central banks in emerging market economies (EMEs), including those in Latin America, appear to have pursued more balanced monetary policies. That is, the policies respond to deviations of both economic activity from some equilibrium level and inflation from target. In the early phase of the recession following the Covid-19 pandemic, Latin American central banks appeared to have a similar countercyclical response as other EMEs, cutting policy interest rates and even employing quantitative easing. But subsequently, they tightened aggressively in response to rising inflation – to a considerably greater extent than advanced economies and many other EMEs. Had Latin American central banks abandoned their balanced approach to monetary policy in favour of a strategy that places overwhelming weight on controlling inflation? To address that question, we focus on the central banks of the five most prominent, inflation-targeting Latin American economies: Brazil, Chile, Colombia, Mexico and Peru.

Contribution

Our paper is one of only a few to analyse the responses of Latin American central banks to the surge in inflation following the pandemic. We show that these responses were stronger than can be explained by a standard linear empirical Taylor Rule model, estimated over the preceding decade. However, they can be explained in large part by a simple non-linear version of the model, in which the elasticity of the policy rate to inflation increases as the inflation rate rises. Despite a substantial literature on estimating non-linear Taylor rules, we found no previous papers that employed our approach incorporating this non-linearity.

Findings

In the years immediately preceding the pandemic, Latin American central banks had responded in a balanced manner to both inflation and output, had substantially smoothed their policy rate movements and had not responded separately to movements in exchange rates. However, we find that during the inflationary surge of 2021–23, monetary policy reacted more strongly and more quickly to changes in inflation than predicted by a standard linear Taylor rule, estimated using data from this pre-pandemic period. Although this appears to represent a shift in the monetary reaction function, we think it more likely that Latin American central banks have been following a non-linear strategy, responding more aggressively to inflation the higher it rose.

Abstract

This paper estimates empirical Taylor rules to analyze the recent monetary policy of the five main Latin American inflation-targeting central banks. We find that during the inflationary surge of 2021–23, monetary policy reacted more strongly and more quickly to changes in inflation than predicted by a standard linear Taylor rule, estimated on data from the pre-pandemic period. Although this appears to represent a shift in the monetary reaction function, we think it more likely that Latin American central banks have been following a non-linear strategy, responding more aggressively to inflation, the higher it rose. We confirmed this by adding the square of inflation to the Taylor rule model: its coefficient was positive and significant, indicating that policy interest rates exhibited a non-linear response to inflation, even during the pre-pandemic period, and the model did a better job of predicting the sharp rise in interest rates during 2021–23. 

JEL Classification: E52, E58, E50

Keywords: Latin America, central banks, monetary policy, Covid-19, interest rates